Monday, June 09, 2008

Internal Margin for your trades

After 3 months of fine trading earlier this year I find myself in a consolidation. My trading results going up, then down, then big down, then up again. As if something in me has changed. Reading this article from Dr. Brett Steenbarger "Getting off the Performance Roller-Coaster" think I found what was going wrong. Overconfidence in my ability to read the longer term market direction correctly. Going so far that I no longer cared where my entry really was, as the contracts I traded were showing such a high volatility, that nearly all trades would show me a profit sometime after my entry. But I coupled that with a desire to squeeze more and more ticks out of the individual trade seeing 50 to 100 tick moves and thinking, that I should be able to get more than 30% out of these moves. Therefore, even with a bad entry I stayed in trades longer than warranted and I did not take the chance to exit when it was offered as I expected follow-through which never materialized as I traded against a longer term trend.

The first time in my trading career I'm going through such a consolidation and I'm not standing with my back at the cliff, where one misstep will throw me in the broken account chasm. And by chance I followed a link to Henry Carstens. In his "Introduction to Testing Trading Ideas" article I found something extremely valuable:

A formula to calculate the Minimum Margin you should apply to all your trades.

You need to know the maximum loss sustained in one individual trade and your Win% and Loss% numbers. I've taken the numbers for 2008, but that's up to you of course. Just make sure, that the number of trades done within the time selected is high enough to give an accurate picture of your trading.

Minimum Margin = (Largest Loss) / (((( 1 + (W% / L%))*W%) - 1) / (W% / L%))

My largest loss this year so far was 5812$, my Win% rate is 63% and my Loss% rate is 12%, the remainder are breakeven trades. I made 377 trades which is high enough to give me statistically meaningful results for my Win% and Loss% rate.

So my Minimum Margin calculates as:
MM = 5812$ / (((( 1 + (63%/12%))*63%)-1)/(63%/12%) = 10347$

I always knew, I should not use less than 10k$ / contract traded and I did so for 3 months, but I violated that rule during the last 4 weeks, when I tried to convince myself to increase size. I did not feel comfortable, but I couldn't put my finger on it, telling myself that I'm just anxious to increase size. Now I have something measurable, something which tells me when it is ok to increase size and when I should still wait.